German government plans to set up an elite university system have met with a storm of protest from students, who have staged naked demonstrations to highlight the crumbling state of Germany's higher education institutions.

"The government has taken the last shirt from our backs," a female student at Berlin's Free University had scrawled across her otherwise bare back. She and fellow protestors turned up to lectures naked this month in a publicity stunt to highlight universities' plight.

While his British counterpart, Tony Blair, faces possible defeat over university top-up fees, Chancellor Gerhard Schröder is feeling the brunt of growing dissatisfaction over his own plans for university funding. On January 9 student demonstrators prevented him from attending Leipzig's failed Olympic bid rally shortly after the government announced its intention to set up at least 10 elite universities to reverse German's recent dramatic decline in education standards.

"We want to change the structure of the German university in order to establish first-class universities and research centres" that can "compete with international top-league schools like Harvard and Stanford," said a guideline adopted at the party conference in the eastern city of Weimar at the start of the year.

Signs of dissatisfaction are widespread. Berlin's universities are decked with the missing shirts and banners hang across the entrances, calling for more basic spending to support the day-to-day running of institutes.

Students resent the call for an "Oxford am Rhine" while the overcrowded "normal" institutes are barely coping; lecture halls are so full that the overflow packs into the corridors outside, forced to watch tutors talk on TV monitors.

The idea of elite universities is the latest attempt by the ruling Social Democratic party (SPD) to stem the decline in standards. German schoolchildren scored in the bottom third of 32 developed nations in basic skills like reading and mathematics, according to an OECD survey in 2002.

The OECD highlighted the education crisis again in a new study that found Germany has one of the lowest graduation rates in the industrialised nations: only 19% of matriculating students reach graduation against the 30% OECD average.

"We'll only be able to remain wealthy enough to afford our welfare system in the years to come if we manage to put Germany at the forefront of innovation," Mr Schröder said after the Weimar meeting.

German know-how remains a world-beater in sectors like automotive and engineering research but lags badly in the money-spinning "new economy" disciplines like biotechnology and electronics.

The OECD says that Germany's three-tier system has stagnated since the 1980s while its neighbours have all improved their systems. Even taking into account the parallel vocational alternative offered to prospective students, German has slipped from fourth to 12th place in the rankings in just the last two years.

Mr Schröder calls for an immediate boost to the system, saying that "education is a central question for our future capability," but the impoverished federal administration is struggling to put his words into action.

"We want to develop this from institutions that already exist, and not set up new institutions on green fields," Mr Schröder promised the party faithful in Weimar.

The elite plan is not binding and the federal government has relatively little to do with education, mostly the responsibility of the 16 states, which by law must provide free education to anyone that qualifies for a place.

The SPD wants to increase spending on education form 2.5% to 3% of GDP by 2010, with two-thirds being provided by companies. Virtually bankrupt, the government is scrabbling about to find new sources of revenue to pay for a spending hike it can't afford.

Last week economics minister Wolfgang Clement caused outrage by suggested that the bulk of the money could be raised from selling off the autobahn system to private investors, an idea that was quickly dropped. A more sober suggestion has been to increase in the inheritance tax and pass a large part of this income on to the universities.

In the meantime the increasingly desperate government has broken open the piggie bank to find the missing cash and is likely to approve last week's request by the Bundesbank to sell a fifth of central bank's gold reserves, some 600 tons, to set up a special investment fund to support research and education.

Academics say the lack of money is only partly to blame for falling standards. The land of Goethe boasts many fine universities that produced some of the world's leading philosophers and scientists in the past. The universities of Freiberg, Heidelberg and Berlin may not be elite but still provide a first class education.

The CHE, a higher education think tank backed by the Bertelsmann Foundation, says that the existing system can be easily improved by introducing more competition and by giving universities more power to choose their students, rather than take what they are given by placement agency ZVS, the German equivalent of UCAS.

"The universities have to be able to choose their own students. Outstanding achievement can only be reached if the individual universities can compete for the best students," the CHE director, Detlef Müller-Bölling told the weekly magazine Spiegel.

The CHF and other academics studying the problem have said that German can no longer afford a "free for all" higher education and call for the introduction of tuition fees, something the left-leaning SPD-Green coalition opposes.